Itaú Should Benefit From High Interest Rates, but Uncertainty in Brazil’s Economy Still Lingers

Equity Analyst

Michael Miller

The challenge for Itaú Unibanco will be to navigate a volatile Brazilian economy and uncertain political environment, which is still working through the impact of high inflation, which exceeded 12% in April 2022 and the high interest rates intended to fight it. While inflation has since moderated, falling to 3.2% in June, the Brazilian central bank has kept interest rates high at 13.75%. The bank benefits from the return of high rates, but there is risk that economic fallout from rapidly increasing rates could lead to lower loan growth and elevated credit losses for the bank. That said, with inflation now well below its peak and in the low single digits, the opportunity for the Brazilian Central bank to achieve a soft landing remains open. 

As pandemic conditions have eased, Itaú has refocused on individual lending, driving the bank's impressive loan growth during 2021 and 2022, with credit cards and mortgages leading the way. With a slew of government guarantee programs for small and midsize enterprises and fiscal stimulus spending, the bank's credit costs during the pandemic were surprisingly low, and a surge in deposits allowed Itaú to expand its loan book significantly. However, weakening economic conditions and high interest rates have caused credit costs to rise in 2023, a trend we expect to continue in the coming quarters. That said, Itaú has healthy reserves, and falling inflation in Brazil means that we do not see foresee material financial strain being placed on the bank. 

Itaú Unibanco appears to be positioning itself as a regional money center in Latin America, with operations across Chile, Uruguay, Paraguay, Colombia, and Argentina. Though there are difficulties in such an approach, the bank has been able to diversify its asset growth and simultaneously reduce its exposure to the notoriously volatile Brazilian real, with nearly 23% of loans outstanding held abroad. On a less positive note, Itaú faces a more hostile approach from regulators in recent years, with the central bank working to increase competition through the launch of the successful Pix payment system and support for the open banking movement.

Business Strategy & Outlook

In our view, Itaú Unibanco does not have an economic moat as the value of its competitive position, which in the past allowed Itaú to irregularly enjoy strong returns, is being eroded by ongoing political and economic instability in Brazil, a more hostile approach from regulators, and increased competition. The Brazilian banking system is highly concentrated with the five largest banks controlling the majority of assets. Moreover, the major Brazilian banks also dominate the payment, asset management, and brokerage industries with a substantial position in the insurance space as well. This dominance within the Brazilian financial system places the major Brazilian banks in a strong competitive position, however, this strong position is needed in order to provide a margin of safety for returns, as the substantial amount of instability and risk associated with Brazil’s economy and regulatory environment causes bank results to be volatile. While Itaú has often been able to earn returns above its cost of capital, aided by non-interest fee income from its large asset management and deposit services segments, the bank has also seen its returns dip below its cost of capital on a somewhat regular basis as shifting economic, political, and regulatory trends impact its business. This is a theme that we expect will continue for the foreseeable future as Brazil sees the return of high inflation and political uncertainty while preexisting budgetary problems remain and the regulatory environment for Brazilian banks has become more hostile. 

In our opinion, bank moats are typically achieved through cost advantages (either through superior funding sources or operational cost structure), switching costs, and the banking system in which the company operates. Itaú has typically had a higher cost of funding than Banco Bradesco, its closest private competitor, with a 4.95% cost of credit versus 4.15% for Banco Bradesco in 2020, though the bank is more in line with its state-controlled peers in this regard. As a result of higher funding costs, as well as its higher exposure to ex-Brazilian lending, the bank has typically trailed Banco Bradesco’s net interest margins, despite generally having higher net charge-offs. 

However, Itaú compensates for this with substantial non-interest income, which makes up over 50% of Itaú’s after-provision net revenue. The bulk of this is generated through account fees, asset management fees, and card interchange/merchant acquiring revenue with these three-line items accounting for just under 35% of Itaú’s total revenue. Margins in this segment of Itaú’s business typically outperform its lending arm, though the two are connected as cross-selling is a key feature of Itaú’s overarching consumer strategy. The fee structure behind its bank accounts is lucrative for Itaú, with high fees for basic services, particularly for accounts with low balances. These fees have historically been accepted by the consumer base, and Itaú’s deposit services revenue grew at a 6.8% CAGR from 2014 to 2019. Additionally, Itaú is the second largest asset manager in the country, another area where fees in Brazil are high relative to international norms. ETF penetration is still low, and many equity funds feature performance fees, akin to those used by hedge funds, pushing average fee loads above 2%. As a result of these lucrative sources of revenue, Itaú’s efficiency ratio is roughly in line with Banco Bradesco and major U.S. banks. 

However, in our view, these strengths are necessary for Itaú to compensate for Brazil’s volatile economic conditions and increasingly unfavorable regulatory climate This is problematic as there are signs that Itaú’s competitive position is weakening, and the Brazilian central bank has made increased competition in the Brazilian financial system a key priority. While asset management fees continue to rise, Itaú’s market share has trended lower over time, falling from 14.8% in 2017 to 12.5% in 2020. This decline was more than offset by a nearly 50% increase in industrywide AUM, but the increased size of the Brazilian investment market has drawn international attention, with BlackRock rolling out new ETF products in the country in 2021. Itaú and the other major Brazilian banks still control a large portion of the distribution channel for investment products, slowing the impact of competitive encroachment, but we see no reason to believe that the Brazilian market will be immune from fee compression over time. 

The Brazilian central bank has become a major proponent of the open banking movement, requiring banks to create the infrastructure and capability necessary to transfer financial data to an external firm at a client’s request. The goal is to enable fintech firms to compete more effectively since they will now be able access the existing data pools of the major banks, easing barriers to entry. In November 2020, the central bank also rolled out the highly successful Pix payment system to offer instantaneous financial transfers to compete with existing payment methods, like credit and debit cards. Firms with more than 500,000 accounts are required to support the payment system and adoption has been rapid, with more than 6 billion transactions from over 110 million users in the first year. This represents a meaningful competitive threat to Itaú’s card and account services revenue (which includes internal and external transfer fees), particularly since Brazilian merchants are allowed to price discriminate based on payment method and the central bank has intentionally set low fees for the service. While the damage from these elements has been modest so far, as card income and asset management fees continue to benefit from secular tailwinds industrywide, these new challenges are still in their early stages and account fee revenue has already begun to stagnate, with annual growth falling from low double digits in the past to low single digits. 

On a macroeconomic level, short-term prospects look increasingly unstable as a pre-existing debt issue runs afoul of the COVID-19 pandemic and rising inflation in Brazil. The Bolsonaro government was able to pass a bipartisan reform in the back half of 2019, raising the minimum retirement age by nine years and potentially saving 800 billion reais over the next decade. While the reform was encouraging, much of the benefit has already been undone through heavy government spending in 2020 and 2021 as it sought to mitigate the impact from the pandemic. The residual drag from bloated pension obligations and coronavirus stimulus measures will be acutely felt moving forward, with gross public debt/GDP rising from 52% in 2013 to 99% by the end of 2020. Additionally, the falling political fortunes of the Bolsonaro government, a consequence of the pandemic and a deteriorating economic situation, has likely ended the prospects of much needed tax and regulatory reform. It has also motivated increased social spending, including higher transfer payments through the Bolsa Familia program (along with a name change in an attempt to take political ownership of the program). This follows a familiar refrain in Brazil of higher social spending during election cycles and has created concerns that Brazil will breach its spending cap, which would further damage confidence in Brazil’s fiscal management.

All this occurs on a backdrop of rapidly rising inflation, higher interest rates, and high unemployment. Inflation rose rapidly in 2021, exceeding 10.5% in October of 2021, a consequence of external supply shocks and fiscal stimulus programs. The central bank has responded by rapidly increasing interest rates in an effort to combat inflation, hiking the SELIC rate from 2.00% in July of 2021 to 7.75% by November, with further increases expected. In our view, this is the correct course of action, but inflation has been a common problem during Brazil’s history, and it remains to be seen if the government is willing to bear economic damage without turning to additional fiscal stimulus to counteract the central bank’s policy. With the Brazilian unemployment rate still above 10%, risk of economic damage from efforts to fight inflation is very real, which could lead to higher charge-offs and lower loan growth for banks. The net result of all of these factors is that while Itaú will likely see its net interest margins recover from their 2020 and 2021 lows, the bank faces substantial macroeconomic risks as the political and economic uncertainty that has been a constant presence in Brazil over the last few years shows no signs of abating, even as the country moves on from the pandemic. 

Outside of direct competition through the state-owned banks, which control roughly one third of banking assets, the Brazilian government involves itself in the Brazilian financial system through a number of regulations. Beyond the more typical reserve requirements, lenders in Brazil face a number of mandatory lending requirements, for example 65% of deposits in savings accounts must be used on real estate-related lending, as well preset interest rates for payroll loans. The intrusion of political goals into the regulatory regime facing Brazilian banks represents an additional operating challenge for the major banks, particularly since regulations in Brazil tend to change quickly and often. There has also been significant instability in the tax rates Brazilian banks face as the sector had been used to help the government solve its budgetary needs while remaining within its spending cap. While the standard statutory tax rate for Brazilian firms is 34%, since 2020 the tax rate for Brazilian banks is 45%. Additionally, in July of 2021 this rate was increased to 50% for the remainder for the year, giving Itaú three different tax rates in three years. Outside of creating tax planning difficulties, the special carveout for Brazilian banks clearly shows a level of hostility to the banking sector and a willingness to use its finances to solve political problems.

All in all, while there are elements of strength to Itaú’s position, given its scale in the Brazilian financial system, that position appears to be weakening in a period where the challenges facing the bank have only grown. While Itaú still has the ability to earn more than its cost of capital under favorable conditions, the bank's strong 2021 results being a demonstration of this, generating excess returns will be more difficult going forward as the operating environment for banks in Brazil is a challenging one and Itaú has less room for error. We also do not expect the increased regulatory attention being placed on the major banks to dissipate, creating the potential for more burdensome regulatory changes or tax increases as the banks remain a political target. As a result, we give Itaú a no-moat rating.

None

Economic Moat

Itau Unibanco Holding S.A.

Itaú Unibanco Holding SA provides financial products and services to individual and corporate clients in Brazil and abroad. It operates through the following segments: Retail Banking, Wholesale Banking, and Activities with the Market and Corporation. The Retail Banking segment includes credit cards, asset management, insurance, pension plan and capitalization products, and a variety of credit products and services for individuals and small companies. The Wholesale Bank segment offers corporate and investment banking activities, including its middle-market banking business. The Activities with the Market and Corporation segment deals with the result arising from capital surplus, subordinated debt surplus and the net balance of tax credits and debts. The company was founded in 1924 and is headquartered in São Paulo, Brazil.

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